Puerto Rico: Don't Believe the Hype

Unlike many other advisory services, we take a historical perspective when it comes to supposedly fresh and new ideas.

And it's for that reason that I've been skeptical of the tax incentives for individuals that Puerto Rico enacted in 2012 to entice hedge fund managers and other wealthy immigrants into relocating from the mainland US. They're the latest in a series of tax incentives that have come – and gone – ever since Puerto Rico became a US possession in 1898 after the Spanish-American War.

Puerto Rico is a US territory. This status, combined with specific tax benefits for Puerto Rico in the US Tax Code, made it possible for the territory to enact the 2012 law ("Act 22"). Among other benefits, this law eliminates all capital gains taxes that accrue after you relocate to Puerto Rico.

The Puerto Rico government, led by Governor Alejandro García Padilla's Popular Democratic Party, is supremely confident of Act 22's staying power. It's even willing to sign a supposedly binding contract with new residents guaranteeing the tax exemptions will remain in place until the end of 2035.

I predicted in this essay that if Congress became concerned enough about these incentives, it would eliminate the federal tax exemptions on income that derives from Puerto Rican sources for individuals who relocate. I think there's at least a 90% likelihood that will happen in the next five years. And if Congress fails to act, I believe Puerto Rico will do so itself.

Now, I realize I'm climbing out on a limb here… the mainstream media and even a lot of expensive offshore newsletters love Act 22. The New York Times and Bloomberg, among other big media outlets, have published fawning articles about the new law. There was even a Puerto Rico Investment Summit earlier this year, where the act's backers pitched hundreds of potential migrants on the idea that the territory was the next tax nirvana.

I don't buy it. The Act 22 incentives, in my mind, fall into the "too good to be true" category.

Now, I realize this isn't what most people want to hear. I also realize that I'm just about the only one saying it. But I'm not the only one thinking it. Not long ago, a true insider got in touch with me. He previously worked directly with the White House on tax matters related to Puerto Rico and other US territories and has more than 30 years of experience in this area. He told me:

"You're the only person I've read who has understood this isn't all it's all cracked up to be."

In his mind, the current situation won't stand. Puerto Rico has been trying such schemes for decades now. They come and go. This one will too.

Here are the facts as he sees them:

Puerto Rico is a US territory. Congress can amend the federal tax code anytime to eliminate the federal tax exemption on Puerto Rico source income in whole or in part. Indeed, Congress could actually repeal Act 22, since it has the authority under the Constitution to "make all needful rules and regulations" for US territories.

Congress and the IRS are ready to act. Senator Charles Schumer (D-NY) is a vocal critic of Act 22 and has expressed his concern to Governor García Padilla. On the other side of the aisle, Senator Charles Grassley (R-Iowa) advocates ending the tax incentives under Act 22 now. Critics like Schumer and Grassley are upset by Puerto Rico's beggar-thy-neighbor tax war with the US, given that the territory still receives around $22 billion from the US every year in the form of aid and subsidies. What's more, the IRS has intensified its investigation of US taxpayers who relocate to Puerto Rico or other US possessions. There is a reason why Puerto Rico hasn't tried this in the past: It makes Washington angry.

The Puerto Rico government lacks the credibility to guarantee that Act 22's benefits will last until 2035. Indeed, the government has already forced investors who purchased bonds of its financially troubled power authority into discussions on reducing payment of the debt. It's even enacted legislation authorizing it to ignore obligations of several government entities.

These incentives come and go. For instance, in 1976, Congress gave US companies the ability to operate in Puerto Rico tax-free. Scores of companies – most prominently those in the pharmaceutical sector – moved to Puerto Rico. But by the mid-1990s, these incentives were costing the US Treasury billions of dollars in tax payments, as companies attributed income to their tax-exempt Puerto Rico operations. So in 1996, Congress overwhelmingly repealed this incentive on a bipartisan basis. Easy come, easy go.

Even if Congress fails to act, my insider contact thinks Puerto Rico will rescind Act 22 on its own. To understand why, put yourself into the shoes of a Puerto Rican resident. You understand why the law was enacted in the first place: A group of hedge fund managers in New York and property developers in Puerto Rico convinced the governor that Act 22 would revive the local economy. Even though the wealthy migrants wouldn't be paying tax there, they'd be buying condos. They'd hire maids, secretaries, maybe even chauffeurs. An economic renaissance would follow.

Well, it hasn't happened. Sure, a few dozen wealthy people have moved to Puerto Rico, bought property there, and even hired a few locals. But Act 22 hasn't led to an improvement in the economy. Puerto Rico still has a public debt exceeding $72 billion, and this year its bonds were downgraded to junk status. Deposits in local banks have fallen 30%, and employment has plummeted more than 20% since 2005. The economic decline has continued despite Act 22, and economists predict it will continue to slide.

To deal with its public debt, Puerto Rico recently raised its capital gains tax from 10% to 15% for existing residents. But at the same time, it's laid out a welcome mat for non-residents to come live there and pay zero capital gains tax.

How would that make you feel if you lived in Puerto Rico all along? If it would upset you, you have a lot in common with many Puerto Rican residents. While elections won't be held again until 2016, the ruling party is trailing in the polls against the leading opposition party, the New Progressives. The New Progressives favor statehood for Puerto Rico. If that happens, of course, all the tax concessions Congress enacted for Puerto Rico would end instantly.

But even if Puerto Rico doesn't become a state, the New Progressives could easily decide to meet Puerto Rico's revenue needs by taxing new residents. In 2011, the party surprised the pharmaceuticals and other manufacturers, who were also largely exempt from territorial taxes under guarantees similar to those in Act 22, by instituting a new levy that has been taking up to $1.9 billion per year away from these companies.

Court challenges against Act 22 are likely as well. The Puerto Rico constitution requires that taxes be applied uniformly. How sympathetic will Puerto Rico courts – and possibly US federal courts – be to the idea that someone with only the most tenuous connection to the territory should receive much better tax treatment than native-born residents?

For all these reasons, Act 22 is doomed. Either Congress, Puerto Rico voters, or the courts will abolish or substantially amend the act, likely with retroactive effect.